What Economic Research Says About Fiscal Austerity and Higher Tax Rates

By Robert P. Murphy

SHARE
POST:

“The case for Keynesian pump-priming is not as solid as some of the Keynesians claim.”

Seeking to influence policymakers and inform the general public, professional economists have been publicly arguing with each other over the “fiscal cliff” in the United States and “austerity measures” in Europe. Several prominent Keynesian economists have written articles for the lay reader implying that it is simply a right-wing myth that tax rates significantly affect economic growth or that reining in the budget deficit with cuts in government spending might be a good idea during a recession. This is despite the sizable amount of theoretical and empirical research backing up such claims. Interestingly, some of this research was authored by today’s loudest critics.

Overstating the Keynesian Case

Consider two classic examples: Nobel laureate and the most famous living Keynesian economist, Paul Krugman; and former head of the Council of Economic Advisors to President Obama, Christina Romer, who is also a well-respected scholar in the field of macroeconomics.

Since the financial crisis struck, Krugman has written dozens of blog posts and columns in the New York Times, criticizing the views of those who worry over budget deficits. The following excerpt from a 2010 article is a good example:

I and others have watched, with amazement and horror, the emergence of a consensus in policy circles in favor of immediate fiscal austerity. That is, somehow it has become conventional wisdom that now is the time to slash spending, despite the fact that the world’s major economies remain deeply depressed.

This conventional wisdom isn’t based on either evidence or careful analysis. Instead, it rests on what we might charitably call sheer speculation, and less charitably call figments of the policy elite’s imagination—specifically, on belief in what I’ve come to think of as the invisible bond vigilante and the confidence fairy. [Bold added.]1

Christina Romer has also warned of the dangers of premature removal of government stimulus spending, but she also took aim at the idea that increases in marginal tax rates could depress economic growth. In a March 2012 New York Times article, she reviewed some of the published literature on the effect of tax rates on the economy and also recounted the large swings in the top U.S. income tax rate throughout the 20th century. Romer commented:

If you can find a consistent relationship between these fluctuations [in tax rates] and sustained economic performance, you’re more creative than I am. Growth was indeed slower in the 1970s than in the ’60s, and tax rates were higher in the ’70s. But growth was stronger in the 1990s than in the 2000s, despite noticeably higher rates in the ’90s.

Given the strong evidence that the incentive effects of marginal rates are small, opponents of such a move will need a new argument. Invoking the myth of terrible supply-side consequences just won’t cut it.2

As these quotations from Krugman and Romer illustrate, many of today’s proponents of Keynesian policy do not simply disagree with their critics, but go further by leading the general public to believe that only the Keynesians have scientific research on their side. This is simply not the case, as I now demonstrate.

Research Showing the Important Effects of Taxes on the Economy

The theoretical case for “supply-side economics” is straightforward: People respond to incentives. By allowing entrepreneurs, investors, and workers to keep a smaller fraction of their last dollar earned, hikes in marginal tax rates discourage business start-ups and investment and reduce labor supply. This is the logic behind conservative and libertarian warnings about proposals to address the long-run U.S. fiscal imbalance through large tax-rate increases on high-income people.

Although the basic theory is unassailable, it remains to test the practical significance of such supply-side effects. Fortunately, scores of peer-reviewed studies do just that. Far from the impression that Christina Romer gives, many economists find that taxes do matter.

Padovano and Galli (2001), for example, used data for 23 OECD countries from 1951 to 1990 and found that high marginal tax rates and tax progressivity were negatively associated with long-term economic growth. In a 2002 follow-up study, these same researchers estimated that an increase of ten percentage points in marginal tax rates decreased the annual rate of economic growth by 0.23 percentage points.

Engen and Skinner (1996) found a relationship twice as strong. They surveyed more than 20 studies looking at tax rates and economic growth in the United States and abroad. They concluded that “a major tax reform reducing all marginal rates by 5 percentage points… is predicted to increase long-term growth rates by between 0.2 and 0.3 percentage points.”

Young Lee and Roger Gordon (2005), concentrating on corporate taxes, reached a similar conclusion. Using data for 70 countries for the period from 1970 to 1997, they found that a reduction of ten percentage points in corporate tax rates raised a country’s growth rate by one to two percentage points. This finding is striking. A one-to-two-percentage-point increase in growth does not add up over time: it compounds over time. An additional percentage point in growth, compounded over 20 years, increases a country’s real GDP by 22 percent.

Ironically, one of the strongest findings—published in the prestigious American Economic Review—came from none other than Christina Romer and co-author David Romer. In a 2010 paper that developed a new measure of fiscal shocks, the Romers classified every major tax-change episode from the U.S. postwar period and listed their conclusions:

Now, it is true that in a subsequent paper (2012), the Romers found a weaker impact of marginal income tax rate changes in the United States during the 1920s and 1930s. Even so, the above block quotation hardly seems consistent with Christina Romer’s description of the published research to the readers of the New York Times. Indeed, a solid literature spanning dozens of countries and decades of history documents that tax policy can have a strong impact on economic performance.

Research Making the Case for “Expansionary Austerity”

The studies cited above are just the tip of the iceberg. There is a large literature empirically documenting the impact of taxes on economic growth. At the same time, many studies have challenged the effectiveness of traditional Keynesian “fiscal stimulus” during recessions. One implication of this line of research is that a country with a growing public debt burden could benefit from a sharp reduction in government spending, even in the short run. This phenomenon has been called “expansionary austerity.”3

There are various theoretical mechanisms through which expansionary austerity can operate. For example, some economists embrace “real business cycle theory” (e.g. Plosser 1989), which explains recessions as the equilibrium result of structural changes in the economy, not as the result of a deficiency in aggregate spending. In this framework, more government deficit spending simply increases the proportion of resources allocated via political, rather than market, means. Households and firms rationally take into account the fact that all government spending must ultimately be paid for (perhaps through inflation or future taxes to service the higher government debt). In this framework, a deficit-financed tax cut is perfectly offset by changes in household saving (through what is known as Ricardian Equivalence4), and even deficit-financed increases in government spending may not stimulate the economy, because households and firms anticipate higher future tax burdens that will be distortionary.

One not need believe in real-business-cycle theory to welcome the possible benefits of fiscal austerity. For example, if a government has run up so much debt that investors begin to question the government’s solvency, interest rates may rise in anticipation, leading to a vicious circle. By adopting politically difficult policy changes to rein in the deficit, the government could send a signal to bond markets and achieve much lower interest rates, which would lower the servicing costs of the government debt and stimulate private investment.

Contrary to Krugman’s and other Keynesians’ characterization, there are many historical examples of “expansionary austerity” apparently working. For example, in its June 2010 bulletin, the European Central Bank (ECB) devoted a section to five case studies of what it called “fiscal consolidation” in euro-area countries.5 The ECB authors explain that fiscal consolidations based on spending reform, rather than on tax increases, are more conducive to economic growth. The ECB report also refers to the academic literature and explains:

The empirical literature offers diverse results as to whether fiscal consolidations in the euro area have had expansionary effects on economic activity in the short run. With reference to the periods of sizeable government debt reductions mentioned above, expansionary fiscal consolidations are suggested in Ireland, the Netherlands and Finland. Looking at a broader range of experiences, it is found that around half of the fiscal consolidations in the EU in the last 30 years have been followed by an improved output growth performance in the short term relative to the initial starting position. (ECB June 2010 Bulletin, p. 85, bold added.)

As Brian Lee Crowley, Niels Veldhuis, and I explained in a recent publication (2012), Canada offers yet another case of expansionary austerity. An earlier study by David R. Henderson (2010) also lucidly explains the Canadian episode. By the mid-1990s, the Canadian federal government had been running deficits for two decades, with one third of federal revenue being absorbed by interest payments. A Wall Street Journal editorial on January 12, 1995 declared that Canada “… has now become an honorary member of the Third World in the unmanageability of its debt problem….”6

Yet the Canadians swiftly solved the crisis with serious reforms. In just two years, from 1995 to 1997, total federal government spending fell by more than seven percent, while the budget deficit of $32 billion (four percent of GDP) was transformed into a $2.5 billion surplus. There were also tax increases, but the ratio of spending cuts to tax increases was about five to one. Canada’s federal government ran 11 consecutive budget surpluses, causing the debt-to-GDP ratio to plummet from 78 percent in 1996 to 39 percent in 2007.

In the decade after reform, Canada out-performed all the other G7 nations on economic growth, investment, and job creation. According to International Monetary Fund data, from 1996 to 2005, Canada’s average growth of real GDP was 3.3 percent, with the United States the runner up with 3.2 percent average growth, and the G7 excluding Canada averaging only 2.1 percent growth.7 Even in the short-term, Canada’s dramatic spending cuts (and moderate tax increases) in the mid-1990s had only mild side effects, causing only a temporary uptick in the unemployment rate.

The interesting thing to note about all of the above examples of successful “expansionary austerity” is that today’s prominent Keynesians do not challenge the accuracy of the historical narrative. Rather, Krugman, for example, has simply denied that any of these episodes is relevant to our current situation, because in each of them, he identifies offsetting measures (in particular, falling interest rates and/or a weaker currency) that cushioned the blow from the fiscal austerity. But since central banks have already cut short-term rates to zero, and because the world as a whole can’t increase its net exports, Krugman thinks these historical examples of expansionary austerity provide little guidance to policymakers today.8

This is quite a turnaround from some of the summary statements we reviewed at the beginning of this article. In reality, there is a long list of successful examples of fiscal austerity, but the Keynesian detractors come up with theoretical reasons to discount their relevance to today’s situation.

Fair enough. So, let’s turn the tables on them and ask: What are the examples of successful Keynesian pump priming, where deficit spending rescued an economy from a deep recession? Today’s Keynesians tell us that the large deficits in 2009 were on the right track, but were just too small. Had they been bigger, they claim, we would have seen with our own eyes the success of the Keynesian models. To repeat the question: What are the examples from history in which the Keynesian model actually worked as advertised?

Here, too, opinions differ, but it’s interesting to quote the assessment from a Nobel laureate in economics, who wrote in 1998:

The point here is that the end of the Depression—which is the usual, indeed perhaps the sole, motivating example for the view that a one-time fiscal stimulus can produce sustained recovery, does not actually appear to fit the story line too well; much though by no means all of the recovery from that particular liquidity trap seems to have depended on inflation expectations that made real interest rates substantially negative.

If temporary fiscal stimulus does not jolt the economy out of its doldrums on a sustained basis, however, then a recovery strategy based on fiscal expansion would have to continue the stimulus over an extended period of time. The question then becomes how much stimulus is needed, for how long—and whether the consequences of that stimulus for government debt are acceptable. (Bold added.)

The writer of this analysis was none other than Paul Krugman, and this was after he had his much-emphasized epiphany on the relevance of old-style Keynesian analysis during a liquidity trap. As the above quote makes clear, as of 1998, Krugman himself thought that there were arguably zero historical examples of a large fiscal stimulus rescuing an economy from a deep recession; perhaps, according to Krugman, even the Great Depression was ended not by war spending, but by the effect of a change in inflation expectations on real interest rates.

Conclusion

Contrary to the claims of some of today’s proponents of both deficit spending and increases in the highest income tax rates, there is a large literature on the historical success of supply-side economics and fiscal austerity based on cuts in government spending. Although the findings of the relevant research are not unanimous, the case for Keynesian pump-priming is not as solid as some of the Keynesians claim. Indeed, in the cases of Paul Krugman and Christina Romer, their own past academic work shows why.

The term “expansionary austerity” has been used in policy debates since the debt crisis broke out in Europe. Wikipedia mentions the phrase (without listing its origin) in the article on a related term, “expansionary fiscal contraction,” which it traces to Giavazzi and Pagano (1990). See: http://en.wikipedia.org/wiki/Expansionary_fiscal_contraction.

*Robert P. Murphy is Senior Economist with the Institute for Energy Research where he specializes in climate change economics. He is the author of The Politically Incorrect Guide to Capitalism (Regnery, 2007) and runs the blog Free Advice.

Enter your email address to subscribe to our monthly newsletter:

RELATED
CONTENT

Alberto Alesina on Fiscal Policy and Austerity

Alberto Alesina of Harvard University talks with EconTalk host Russ Roberts about his research on fiscal policy and austerity. Alesina's research shows that spending cuts to reduce budget deficits are less harmful than tax increases. Alesina discusses the intuition behind this empirical finding and discusses other issues such as Greece's financial situation.